There are two major competing philosophies when it comes to investing: do I invest in a lump sum, or do I invest in small chunks (i.e. dollar-cost averaging)?
It also seems that almost every financial analyst has a different perspective when it comes to how to invest. Many recommend investing in small chunks and dollar cost averaging into your portfolio. This is the philosophy embraced by many TV personalities like Suze Orman. She is against investing in lump sums because she equates it to trying to time the market.
However, research on historical returns has shown that investing in a lump sum may actually be the better way to go. Here are the pros and cons of each.
The Pros of Dollar Cost Averaging
The biggest advantage of dollar cost averaging is the ability to invest small chunks over time. The best example of consistent dollar cost averaging would be your 401k. You invest a small amount every-other week with your paycheck (say, $100). Then, over time, your investments will smooth out the volatility in the daily stock market. The idea is that with the same $100, you’ll buy more shares when stock prices are low, and less shares when stock prices are high. That sounds appealing.
Dollar cost averaging makes a lot of sense in two key situations:
- You Don’t Have The Money Upfront
- You Have a Hard Time Investing in the Stock Market
If you don’t have the money upfront, investing a little at a time can be a great way to build an investment portfolio.
Also, if you have a hard time investing – whether emotionally or just have trouble saving – dollar cost averaging into the market can help you psychologically get started investing. By investing in a small amount, say $100 per month, you can feel like you’re building a portfolio, while not worrying too much about price and volatility. That way, you can build savings,while minimizing the emotional toll of the stock market’s price movements.
But dollar cost averaging isn’t all that it’s cracked up to be by the financial pundits.
The Cons of Dollar Cost Averaging
There are two major disadvantages to dollar cost averaging.
- It Hurts Diversification and Portfolio Allocation
- It Doesn’t Make Sense if you have a Lump Sum
Believe it or not, but dollar cost averaging has a negative effect on your portfolio allocation, which can diminish returns over time. Since dollar-cost averaging makes it difficult to get your ideal target allocation, and if you’re working towards it with sequential investments, you may not get to it for a long period of time, you run the risk of not capitalizing on stock market returns.
And if you have a lump sum, you’re actually in a more ideal position to instantly invest into your target asset allocation. Historical returns show that lump sum investing has yielded higher returns 66% of the time. You can check it yourself using this calculator: Does Dollar Cost Averaging Work? So, if you have a lump sum, you probably shouldn’t dollar-cost average it either.
The Alternative – Investing in a Lump Sum
The better way to invest is to take a lump sum and invest in your target allocation in one move. The thought behind this strategy is that you can get to your ideal asset allocation immediately, and start taking advantage of market returns. Since statistics are in your favor (66% of the time), this can make sense for most non-emotional investors.
There are two unique scenarios where dollar-cost averaging wins every time, that you should be aware of. First, if you invest your lump sum right before a market crash (October 1987, October 2007), dollar cost averaging will outperform over time. Second, if you invest directly before a market slump (think summer of 2000), where there is no market crash, but a drastic decline over a longer period of time, dollar cost averaging will also outperform.
I’m personally a lump sum investor. I prefer to keep my money in a cash account, like a savings account, until I’ve decided where I want to invest. This strategy has proven very successful for me over time, because I’ve been able to take advantage during odd market movements. Two examples in recent his history:
- My Best Investing Day Ever
- I invested in oil companies like Chevron and Exxon after the BP spill when the oil sector was beaten down
When there is broad market, or broad sector sell-offs, having a pile of cash on hand to invest in allows you to profit down the road. This is also very similar to what Warren Buffett does, by stockpiling cash until the time is right. I also recommend this strategy in my College Student’s Guide to Investing.
However, I do dollar-cost average as well, specifically in my 401k. However, I also try to make sure that my 401k jives with my total portfolio allocation, and is not just a stand-alone investment. So, even though dollar-cost averaging takes place, I try to not let it impact my overall allocation strategy.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
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Interesting, I never considered that cost averaging could help you avoid the volatility in the market. How about leaving cost averaging to retirement funds, lump sum to your own personal picks and then cost averaging on those dividends?
Also, what is the smallest lump sum you would want before you turn it into an investment?
Andrew – keep in mind that if you dollar-cost average, you don’t always get to take advantage on pricing and asset allocation. That’s why with lump sum investing, you can go right to your target allocation instantly. If you dollar-cost average dividends (i.e. dividend reinvestment), you may get out of your target allocation if you’re not vigilant.
As for the smallest lump sum, I’d keep it relative to the commission charged. I usually invest at least $1,000 each time – then a $7 commission is only 0.7% of the amount invested, and the lower the better. There are plans like Sharebuilder that offer $4 commissions on their automatic investing plans, but that isn’t much savings.
Interesting, how diversified do you usually get? No more than $1k in a particular holding? I like to invest myself (as opposed to an index fund or similar) so I set my goal at beating the index. I’m obsessed with diversity yet the more diverse you get I find it gets harder to beat the indexes. You’ve gotta be consistently awesome with your picks.
Have you been able to beat the market?
Yes, but like I mentioned, I rely on index funds in my 401k, and then pick stocks for my regular portfolio and IRA. I have been able to beat the market by roughly 3.5% compared to the S&P500.
I really could go either way on this. Dollar Cost Averaging has its benefits, as you pointed out. I think it can be good for someone who either does not have the time or knowledge level to be investing on a regular basis. That said, I also think lump sum can be a great way to go as well. I think this is key in times like we’re seeing in which you’re generally losing money by just sitting on it in a savings account. I’d rather take the risk to earn more as opposed to just sitting on it.
John, but if you take risk for no reason just “to invest it”, and you lose, and then a real good investment comes along, you may not be poised to take advantage of it.
I’m with you: lump sum is the way to go. The funny thing is, when I was an advisor, I was a dollar cost averaging junkie. Why? Because clients wanted to see wins and it was easier to show them wins with dollar cost averaging. If we hit the market on one of the roughly 40% of days that it goes south, some investors (who thought I should have a crystal ball) would blame me.
I always invest using dollar cost averaging. I don’t believe in the lump sum method because I don’t that 100% right on your first try. Dollar cost averaging gives multiple shots at getting the price you want.
I dollar cost average my retirement which is all in one fund so I don’t have to worry about allocation. I also don’t have a lump sum so it is what works best for me.
Probably beter in your situation to dollar cost average. However, be careful with the trouble with target date funds.
I tend to dollar cost average, via the 401k. That being said, I do think that there are times when one can invest when the market gets pummeled. It seems like there is often overreaction to bad news, particularly when people think a bad event will lead to broad market problems. Those infrequent instances can be true buying opportunities, where having cash on hand can allow for larger scale opportunistic buying.
I dollar cost average across an array of blue chip dividend stocks that are trading at a discount. Every paycheck I purchase a set amount of shares from the companies that are the cheapest.
I personally invest lump sum into individual stocks (I ‘ve been building up a passive dividend income stream for years), mainly because I want to get a large dividend contribution from a stock at the time I believe the price is right.
In my 401k, or other index funds, I ‘ve been dollar cost averaging those for years with monthly contributions.
So i guess I use both methods 🙂